Investors Look to Cheap Hedges Ahead of Fed Announcement

The Federal Reserve isn’t expected to pull back on its easing efforts at this week’s meeting, but some investors are buying cheap insurance in the form of stock options in case the Fed spooks the markets.

Recent sessions have seen stepped up buying of low-price stock options that would profit should stocks suffer big declines on the order of 10%, 15% and even 22% this week. It is not that these buyers expect such massive declines, but rather, the value of those options would likely jump should stocks see a fresh bout of volatility on news from the Fed.

Stocks have traded erratically for weeks now as investors have debated whether the Federal Reserve will start cutting back on its $85-billion-a-month bond-purchase program this week and what such a move would mean for stocks. Some investors worry that a shift by the Fed at this point could derail a fragile economic recovery and take the air out of stocks, which have risen 25.3% so far this year. Others believe stocks could weather a tapering of bond purchases.

Amid this uncertainty, and with many investors sitting on big gains in the stock market, trading volume has climbed in options contracts that can hedge a broad stock portfolio or speculate on a sharp drop in shares. At the end of last week, the total number of bearish S&P 500 options contracts outstanding stood at 9.5 million, a three-month high.

At the same time, there has been a rise in the Chicago Board Options Exchange Volatility Index, known as the stock market’s fear gauge. The index, which typically moves inversely to stocks, rose Monday despite a strong gain in the market as the up day failed to assuage concern. On Tuesday, it rose further, gaining 1.4% to 16.26, its highest level in more than eight weeks.

“Over the last few days, the trading has been a little more pessimistic with an increase in fear,” as some investors ratcheted up the chance that the Fed might move sooner than is widely expected, said Amy Wu, equity derivatives strategist at RBC Capital Markets in New York.

“Two weeks ago, people were thinking it was highly unlikely that the Fed would change anything, but now, consensus seems to give it 30% likelihood,” Ms. Wu said.

And with the odds of a shift deemed somewhat higher, some investors have turned to the options market for protection.

Some big investors, such as hedge funds, are holding a heavier weighting of stocks going into the end of the year as they try to keep pace with the big stock-market rally, said Ramon Verastegui, head of derivatives strategy at Société Générale in New York.

That has played out in more-active trading among so-called out-of-the-money options–options pegged to S&P 500 levels that the market is extremely unlikely to attain before they expire. These options trade at relatively low prices because of the high risk of expiring worthless.

On Friday, the largest trade in S&P 500 options involved the purchase of 4,670 December 1510 put options, which expire at the end of the week. That position profits should the S&P 500 drop below 1510, a 15% decline. The cost for these options is $15 per contract. That compares to a price of $70 a contract for options that look for the market to drop 5% through the end of the week to profit.

On Monday, the biggest trade in S&P 500 options was the purchase of 5,100 Dec. 27 1610 puts, which look for a drop of more than 9.9% over the next two weeks. That trade was a little pricier, at $80 a contract, or a total of $408,000. Meanwhile, December 1400 puts, which need the benchmark stock-index to drop more than 22% before the week is out, had the second-most S&P 500 contracts outstanding as of Tuesday, with about 167,000 existing positions.

Those positions don’t need a big drop in stock prices to make money, said Mr. Verastegui, but just a sharp rise in expected volatility. That could cause options prices to rise rapidly, leaving the buyers the chance to profit by selling out of the position at a higher price than they bought in.

These investors “are buying really out-of-the-money options because they want to hedge an extreme event,” he said.